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University Business School

Cost And Regression Analysis


Based On The Financials Of BILT
Nipun Goyal
1/9/2011

Cost Regression Analysis (CRA) is an applied statistical technique which focues on the most relevant causal factors underlying todays tough decision. Through iterative modeling of various data elements, CRA helps make the relationships between individual variables apparent. Procurement teams can use these findings to, amongst other things model should costs, identify savings opportunities not previously known and negotiates pricing variances.

AN INTRODUCTION TO REGRESSION ANALYSIS

egression analysis is a statistical tool for the investigation of relationships between variables. Regression analysis includes any techniques for modeling and analyzing several variables, when the focus is on the relationship between a Rdependent variable and one or more Rindependent variables. More specifically, regression analysis helps one understand how the typical value of the dependent variable changes when any one of the independent variables is varied, while the other independent variables are held fixed. Regression analysis is widely used for prediction and forecasting, where its use has substantial overlap with the field of machine learning. Regression analysis is also used to understand which among the independent variables are related to the dependent variable, and to explore the forms of these relationships. In restricted circumstances, regression analysis can be used to infer causal relationships between the independent and dependent variables. A large body of techniques for carrying out regression analysis has been developed. Familiar methods such as linear regression and ordinary least squares regression are parametric, in that the regression function is defined in terms of a finite number of unknown parameters that are estimated from the data. Nonparametric regression refers to techniques that allow the regression function to lie in a specified set of functions, which may be infinitedimensional.

LINEAR REGRESSION

inear regression is an approach to modeling the relationship between a scalar variable y and one or more variables denoted X. In linear regression, Ldata are modeled using linear functions, and unknown model Lparameters are Lestimated from the data. Such models are called Llinear models. The various regression equations which can be used for forecasting exercise are: Fitting Simple Linear Regression: In this case a straight line is fitted to the data containing one dependent variable and only one independent variable, e.g., Sales = a + b*(Price)

Fitting of the straight line can be done by following methods: i. Graphical Method ii. Least Squares Method i. Graphical Method: In graphical method, we plot the sets of data of the two variable (dependent and independent variable) on the graph and a line is drawn through all the points. Thereafter, the movement of the series is assessed and future values of the variable are forecasted.

Figure 1.0 shows how to project trend by graphical method, using the figures on sales for paper products from the numerical example of Ballarpur Industries Limited cited below:

YEAR 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

BILT SALES (in Rs. Crores)

1578 1553 2146 2280 2011 2085 2376 1050 1076


1,100.00

ii.

Least Squares Method: Least squares estimation is a powerful tool to estimate the coefficients of a linear function. It is based on the minimisation of squared deviations between the best fitting line and the original observations given. In this method, we fit the data on demand and time in the form of equations and then project the demand for the future period. These equations are termed as normal equations and the task of least square method is to find out the values of the coefficients in these equations. Figure 1.0 Graphical Trend

The Equation of the linear trend is given by: Y =a + b X, where a is the intercept of the demand curve, b is the slope of the curve(a and b are known as regression coefficients) and X is the deviation from mean of independent variable. We can find the values of a and b using the normal equations: Y= na + bX Y.X= aX + bX2 Let us explain linear trend projection with the help of a numerical example, data being the same as taken in the graphical method: Here n=9, i.e. , odd and therefore, we shift the origin to the middle time period, viz., the year 2006.
COMPUTATION OF TREND VALUES
BILT SALES (in Rs. Crores) (Y)

YEAR (t) 2002 2003 2004 2005 2006 2007 2008 2009 2010

X=t middle point -4 -3 -2 -1 0 1 2 3 4 X= 0

X2 16 9 4 1 0 1 4 9 16 X2= 60

XY -6212 -6438 -4560 -2011 0 2376 2100 3228 4400 XY= -7117

TREND VALUES Y= 1740.77 118.61X 2215.21 2096.6 1977.99 1859.38 1740.77 1622.16 1503.55 1384.94 1266.33

1553 2146 2280 2011 2085 2376 1050 1076


1,100.00

Y= 15677

The equation for linear trend is given by Y= a + bX The normal equations for estimating a and b are: Y= na + bX 15667= 9a + 0 and Y.X= aX + bX2 -7117= 0 + 60b

a= 15667/9 a= 1740.77 Solving the normal equations we get a= 1740.77 and b= -118.61 Hence the equation for linear trend is Y= 1740.77 + (-118.61)X i.e. Y= 1740.77 118.61X

b= -7117/60 b= -118.61

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Trend values for the years 2002 to 2010 are obtained on putting the value of X corresponding to the given year and have been tabulated in the last column of table drawn above. Similarly, we can find the estimate sales of the commodity for 2011 and same will be obtained on putting X= 5 in * equation, i.e. Y2011= 1740.77 118.61 X 5 = 1147.72(Rs. In Crores)

all figures in billion Rs.. INCOME (X) 20.2 21.7 25.6 31.9 30 40.3 X= 169.7

INCOME VS RAW MATERIAL EXPENSES


TREND VALUES Y= -3.576 + 0.546 X 7.4532 8.2722 10.4016 13.8414 12.804 18.4278

YEAR 2005 2006 2007 2008 2009 2010

RAW MATERIAL EXPENSES (Y) 7.4 8.1 10.3 12.8 13.4 19.2 Y= 71.2

X2 408.04 470.89 655.36 1017.6 1 900 1624.0 9 X = 5076


2

X.Y 149.48 175.77 263.68 408.32 402 773.76 X.Y= 2173

NON LINEAR REGRESSION

onlinear regression is a form of Nregression analysis in which observational data are modeled by a function which is a nonlinear combination of the model parameters and depends on one or more independent variables. The non linear equation can take any one of the forms : parabolic, logarithmic, exponential etc. depending on the way the trend of the dependent variable behaves. Fitting Non-Linear Regression: Some of the popular methods are the following: i. Logarithmic Model: Y= abX Taking logarithm on both sides, we get , LogY= Log a + X Log i.e. Y1= A + B.X ,where Y1= Log Y , A= Log a and B= Log b Normal Equations for estimating A and B are: Y= nA + BX X.Y= AX + BX2 We solve these equations to get the value of A and B and finally we get, a= antilog A and b= antilog B. ii. Parabolic Regression Model: Sometimes we need to fit a curved trend line which by a change in variable, could not be reduced to a linear form. The curved line can be second degree polynomial or third degree polynomial etc. Let us assume that it is a second degree polynomial given by the equation: Y= a +b.X+c.X2 The normal equations for calculating a, b and c are: Y= na + bX+ cX2 X.Y= aX + bX2 + cX3 X2.Y= aX2 + bX3 + cX4

iii. Multiple Regression Analysis: When more than one independent variable is taken in the regression model, we get multiple regression coefficients and equations. A multiple regression model, say for sales, may be stated as: Sales = a.price + b.advertising + c.income + d.rivals price levels + e.personal disposable income + u, where a, b, c, d and e are the partial regression coefficients which show the effect of corresponding variables on sales. For example, a represents the percentage change in sales as a result of 1% change in price, other things remain constant. Similarly b shows the percentage change in sales as a result of 1% change in advertising outlay and so on. The constant u represents the effect of all the variables which have been left out in the equation but have an effect on sales. In the above equation, sales is the dependent variable and all the variables on the right hand side of the equation are independent variables. If the expected values of the independent variables are substituted in the equation, the sales will be forecasted. The main advantage of this model is that the effect of a large number of variables can be taken into account. Also, this type of model enables the businessman to experiment with what might happen under extreme or unlikely conditions. He might for example, like to find out the effect of doubling of his rivals price, or reducing his own advertising outlay on his total sales. He can simply inject these values into the model and get the required results.